Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes

In this paper, we propose the possibility that the mortgage boom and bust crisis of 2007–2009 might have been caused by financial innovation. We suggest that the astounding rise in subprime and Alt A leverage from 2000 to 2006, together with the remarkable growth in securitization and tranching throughout the 1990s and early 2000s, raised the prices of the underlying assets such as houses and mortgage bonds. We further raise the possibility that the introduction of Credit Default Swaps (CDS), in 2005 and 2006 brought those prices crashing down with just the tiniest spark. Securitization and tranching did not happen over night. The securitization of mortgages by the government agencies Fannie Mae and Freddie Mac began in earnest in the 1970s, when the first pools of mortgages were assembled and shares were sold to investors. In 1986, Salomon and First Boston created the first tranches, buying Fannie and Freddie pools and cutting them into four pieces. This was no simple task because it involved not only special tax treatment by the government but also the creation of special legal entities and trusts which would collect the homeowner payments and then divide them up among the bondholders. By the middle 1990s, the greatest mortgage powerhouse was the investment bank Kidder Peabody, cutting hundreds of billions of dollars worth of mortgage pools into over 90 types of tranches called CMOs (collateralized mortgage obligations). These tranches bore esoteric names like floater, inverse floater, IO, PO, inverse IO, Pac, Tac, etc. The young traders, often in their mid-20s, who collectively engineered Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes